“One swallow does not a summer make, nor one fine day“
Last week, we discussed the most recent monetary policy decision meetings from the Fed, ECB and BoE - Important, incremental decisions that highlight different stages of the respective hiking cycles with respect to the differing balance of growth and inflation on the risks to aggregate demand.
The BoE hiked 50bps but indicated that they are likely close to, or already at, the end of their hiking cycle for now as economic growth risks counter the immediate upside risks to inflation. Indeed, it is clear from the inflation projections, that unless the upside risks to inflation that the BoE fear materialise, then the balance of risks to interest rates is likely to the downside (inflation projections conditioned on market rates show inflation at just 0.37% at the forecast horizon).
The ECB hiked rates 50bps and made it clear that, unless there is a material slowing of growth and or inflation that they expect to raise rates a further 50bps at the March meeting. Essentially the ECB, with core inflation running at more than double the target and with concerns over the pace of wage inflation in train through wage bargaining rounds, see a higher balance of risks from inflation than growth.
The Fed are essentially somewhere in between. Chair of the Fed was clear that it is important that inflation is brought under control, but at the same time emphasised that the deflationary process is underway and that by extension emphasised the point that we have made for some time now - that as inflation falls, real rates in the US rise, and thus the degree of restrictiveness of policy increases. Against this backdrop, the concept of ‘sufficiently restrictive’ is not static (i.e. it can be achieved either by higher rates, or lower inflation). Chair of the Feds more data dependent stance (without pre-empting the revised economic projections and dots in March) is likely a nod to this dynamic.
In the UK inflation must prove that it is the risk that the BoE fears in order to avoid rate cuts later this year. In the US rates are likely more dependent on the policy mix - economic stability and anything but falling inflation leaves the Fed likely to err on the side of a higher terminal rate. Market attention is thus squarely focussed on the data
The policy relevant horizon
Between the February 1st policy meeting and the March 22nd meeting there are two employment reports and two inflation reports. While other data will shape the debate, the Fed’s dual mandate - price stability and maximum employment - means that the employment and inflation prints will dominate. Indeed, if there is one data point most relevant, it is likely the Average Hourly earnings component of the employment report. Wage gains, or tightness of the labour market, and their impact on headline inflation are key to the considerations of the Fed.
In December we began to discuss the prospect that the Fed will be ‘one and done’ in 2023. We still see that as a very plausible scenario. The January employment report dented the thesis somewhat. The employment report for January was, on the face of it, strong. However, we also believe that it was anomalous and misleading from a policy perspective.
Anomalous, because of three reasons, or distortions: (i) Weather - better weather led to significant retention of staff relative to seasonal comparisons, (ii) Strikes - the return of a significant sector of academia after strike action in December added significant numbers and, (iii) the seasonal adjustment itself should be questioned, or at least acknowledged after two consecutive COVID lockdowns over year end substantially distort the adjustment - the February report will be considerably weaker in our view.
Misleading, because of the readthrough from the perception of a tight labour market to higher aggregate demand and thus widespread price pressure. In our view, against a near daily announcement from corporate America of significant job cuts, overall metrics that suggest a tight labour market are potentially misleading. This is due to the fact that the ‘tightness’ in the labour market is at the low end of the pay spectrum - the squeezed middle is not seeing labour market tightness, no significant real wage gains and is hurt the most by higher nominal prices, interest rates and falling asset valuations. On aggregate, therefore, it is likely possible that the jobs market appears ‘tight’ through measures such as the jobs gap, but that average hourly earnings and aggregate demand continue to fall.
Ultimately, we maintain the view that inflation will continue to fall this year, led by goods prices but also by slowing demand and very high absolute prices in some service sectors (it is no wonder hotel bookings are falling with the current absolute level of room prices - many sectors that got a prolonged boost from COVID reopening may find current prices are unsustainable). Against this backdrop we retain the view that there is likely a non-linear downside risk to consumer demand (as a function of COVID stimulus induced excess savings depletion, declining house prices, higher debt servicing costs, credit card spending gains, etc…).
The payroll jump may have added volatility to the trend, and may even have created enough uncertainty that the Fed err on the side of inflation caution, but in our view the disinflation trend will ultimately be dominant.
In the UK, the economic backdrop is undoubtedly more fragile, but signs of a loosening in the labour market (where it shares many similarities to the tightness in the US) are encouraging. This week, GDP data showed that the UK narrowly avoided a ‘technical recession’, for now at least - the data will be revised. Next week’s suite of data (Employment, CPI and retail sales) will give an important update on the inflation, labour market, economic activity of the UK. Perfect timing for markets to calibrate their response to the heavy hints of the BoE that policy tightening is likely done - for now. Worthy of note, not just from the perspective of the UK rate curve, but also for potential leading indicators for other economies and central banks.
Since its release, the US employment report for January has got a lot of press. Indeed, it has caused a number of commentators to reverse their views on yields, duration, curve and the USD. We are not convinced. To paraphrase Aristotle, while the data may have given US yields and the USD “one fine day” we caution that “one swallow does not a summer make”!
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Federal Reserve Minutes, February 2023: https://www.federalreserve.gov/monetarypolicy/fomcpresconf20230201.htm
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